What Is Inheritance Tax: Definition & Who Pays It?
Losing a loved one is already an incredibly stressful experience and when you add in the confusion that often surrounds inheritance tax, that stress will only grow.
At tough times like this, it can be helpful to get a full understanding of exactly what is expected of you, and how things around you work.
That’s why we’ve put together this piece. So what exactly is inheritance tax? Read on as we take you through a full guide of what it is, how it works, how it’s calculated, and who exactly pays it.
Table of Contents
- An assessment on property acquired from a deceased person is known as inheritance tax.
- An inheritance tax is assessed on the value of the inheritance received by the beneficiary. This is as opposed to the estate tax, which is assessed on the value of an estate and paid by it.
- There is no federal inheritance tax. However, residents of Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania may be subject to taxes on inherited assets.
- By leaving money to heirs through trusts, insurance policies, or by making gifts during one’s lifetime, inheritance taxes can be reduced or even completely avoided.
What Is Inheritance Tax?
An inheritance tax is a charge that some states levy on individuals who inherit property. Unlike an estate tax, which is paid by the decedent’s estate, an inheritance tax is paid by the beneficiary of a bequest.
Because the tax is uncommon in the United States, it depends on the state where the deceased resided or owned property, the amount of the inheritance, and the beneficiary’s relationship to the decedent to determine whether it applies in one of the six states that have an inheritance tax as of 2022.
How Inheritance Taxes Are Calculated
Only the amount of an inheritance that surpasses an exemption level is subject to an inheritance tax. Tax is typically applied on a sliding scale above such levels. Rates often start out in single digits and increase from 15% to 18%. More so than the size of the assets you are receiving, your relationship with the deceased may affect both the exemption you obtain and the rate you pay.
Generally speaking, the larger the exemption and the smaller the cost you’ll pay, the closer your familial connection to the deceased was. In all six states, surviving spouses are immune from inheritance taxes. Also exempt in New Jersey are domestic partners. Only Nebraska and Pennsylvania impose inheritance taxes on heirs.
How Inheritance Tax Works
In the United States, there is no federal inheritance tax. Large estates are subject to direct taxation by the U.S. government, which levies estate taxes and, if applicable, income taxes on any gains from the estate. However, beneficiaries of an estate are not subject to inheritance taxes.
Six states in the United States—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—collect inheritance taxes. The amount of your inheritance, your relationship to the decedent, and local tax laws will all determine whether and how much of it will be taxed.
The state or states where the decedent resided or had property may impose an inheritance tax.
How to Avoid Inheritance Tax
Even though there are several exclusions and exemptions from inheritance taxes, particularly for spouses and children, residents of states that have them may still seek to reduce the exposure for heirs.
One popular method is to purchase a life insurance policy in the amount you want to leave as a bequest and name the beneficiary of the policy as the person you want to receive it. Inheritance taxes do not apply to the death benefit of an insurance policy.
Another option is to place your assets in a trust, preferably an irrevocable one. As a result, they are no longer considered part of your estate and are no longer considered an inheritance when you pass away. When you create the trust, you can specify a timeline for how the money will be distributed.
Only inhabitants of six states are subject to inheritance taxes. Additionally, they primarily apply to distant relatives or others who had no connection to the deceased. The immediate family—parents, children—as well as spouses, are frequently exempt. If they are taxed at all, siblings, grandkids, and grandparents are given preferential treatment (larger exemptions, lower rates).
Even so, relatively tiny inheritance amounts—sometimes as low as $500—can trigger inheritance taxes. Consider estate-planning techniques including gifts, insurance policies, and irrevocable trusts if you’re thinking about leaving a legacy that might be susceptible to inheritance taxes.
FAQS About Inheritance Tax
Depending on the quantity of the inheritance and the heir’s familial connection to the deceased, the six U.S. states that impose inheritance taxes offer different exemptions. As of 2022, the federal estate tax exemption exempts $12.06 million from tax. Inheritances are not subject to income tax at the federal level but can be taxed at state level.
Estate tax and inheritance tax are not the same thing. Before assets are transferred, the estate is subject to an estate tax, whilst the beneficiaries of a bequest may be subject to an inheritance tax.
There are currently 33 states that have no inheritance tax. For a list of these states, visit the IRS website.
There is no federal inheritance tax, which is a charge on the total amount of assets a person inherits from a decedent. For 2021 and 2022, however, estates worth more than $11.7 million and $12.06 million, respectively, are subject to a federal estate tax. Only the portion of an estate that exceeds such sums is subject to tax. The rate ranges from 18% to 40% on a sliding scale.
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